Is there an alternative to the mortgage?

Why does buying a house involve taking out so much debt?

OK yes, there is, of course, a pretty obvious answer to this: it’s incredibly expensive. Few Britons have a spare £245,000 lying around (the average UK house price as of September) so they need a little help to afford it. They put up a deposit, which can typically be as small as 5% or as big as 25% (or bigger still); the rest they have to seek from elsewhere, and that’s where mortgages come in – a massive multi-decade long debt which involves a sizeable amount of interest and a sizeable amount of risk.

After all, if you’ve got a 95% mortgage and house prices fall by 10%, you’ll find yourself stuck in a house which is worth 5% less than the mortgage you’re paying off. Negative equity, as it’s called, is one of the biggest problems that can afflict the housing market, sometimes forcing households into foreclosing, invariably preventing homeowners from moving home as and when they need to.

All of which is why a lot of people have questioned the wisdom of the Government attempting to encourage more prospective buyers to take out 95% mortgages through its Help to Buy scheme, one part of which effectively part-finances homebuyers’ mortgages. Given Britain is already highly indebted, is more debt really the answer?

Ideally not, according to David Miles, one of the members of the Bank of England’s Monetary Policy Committee. Miles, who is also one of the country’s foremost mortgage experts, has given a speech tonight which concludes that over-reliance on mortgage debt is one of the big problems facing Britain’s economy and financial system. As he puts it, “It is very hard to believe that the volatility in housing market outcomes, and the rise in defaults on mortgages, we have seen in recent years in many rich countries is anything other than harmful.”

But what’s the solution – is there any way of buying a house without taking out so much debt? He thinks that we should be looking towards the business world for an answer. When companies need to invest in property (or building new factories, or taking on staff) they don’t just go to the bank for the cash, they also tap equity markets, issuing shares in exchange for funds. The primary difference between equity and debt being that shareholders get less in the way of regular repayments but legally own a fraction of the company.

So, Miles asks, why couldn’t the same principle work with property? Why couldn’t buyers borrow a certain chunk from the bank and essentially sell equity in a certain chunk of the property they’re buying. The mortgage part would look like any other mortgage. The equity bit would be more intriguing: those who bought equity in your home would benefit if the house price rose, they would perhaps get an occasional fee (rather like a dividend) but they would also take some of the hit if the price fell (just as a shareholder loses out if the share price falls, and in the event of default takes the first hit). According to Miles’s sums, under one scenario homeowners could effectively insure themselves against 50% of any falls in their property, if they committed to giving up around 36% of any prospective house price gain to the equity holders.

The advantage is that homeowners would be significantly less exposed to the risk of default and foreclosure. It’s a nice idea – but would it work in practice? That seems less clear. There have been a few efforts at shared equity schemes such as this – most notably the first half of the Government’s Help to Buy scheme, which is actually a shared-equity plan for new-build homes which is quite different to the mortgage guarantee scheme to support deposits (the bit almost every economist thinks would be a disaster). However, it’s early days and historically there’s been little prolonged widespread take-up for schemes like this.

Though it’s an elegant idea and makes plenty of economic sense, there’s another pragmatic reason to be a little sceptical. In practice, many homeowners regard their property as an investment which will net them significant gains in the coming years. This notion is rather wrong-headed, but it is nonetheless deeply ingrained in the national psyche. So would prospective homeowners really want to give up their rights to any future gains from their house price?

Either way, it’s a fascinating idea. Moreover, it is a subtle warning to the Chancellor, who is hinging at least part of his economic recovery on a debt-driven increase in housing market activity. More debt is not the answer – and yet this seems to be the direction Britain’s households are being pushed towards.